Is Warren Buffett Crazy?

Given the relentless barrage of bad news about the U.S. banking system and the near-constant calls for the government to nationalize the country’s biggest banks, you couldn’t be faulted for wondering if Warren Buffett had lost his mind when, in a three-hour appearance on CNBC Tuesday, he called this “a great time to be in banking,” talked about the massive “earnings power” of banks like Wells Fargo, and said that the government actually doesn’t need to supply most banks with “lots of capital.” (Another explanation for Buffett’s relatively upbeat forecast was that, in industry parlance, he was just “talking his book,” since he has big stakes in banks like Wells Fargo and U.S. Bancorp.) But the truth is that the recent history of U.S. banking suggests there’s a chance, at least, that Buffett was right.

The key to understanding Buffett’s less-than-apocalyptic take on the banks is the idea of the spread: the gap between the interest rate banks can charge for the loans they make and the interest rate they have to pay for the money they borrow — from depositors or other lenders. When the Federal Reserve slashes interest rates, particularly when they slash them as aggressively as they have in the past year, spreads widen, so that every loan a bank issues becomes more profitable. And that’s especially true today, because the risk aversion of investors and financial institutions has meant that the interest rates on loans have fallen less than they normally would have, given the steep decline in the fed funds rate. Buffett, for instance, said that in the fourth quarter of 2008, Wells Fargo’s cost of funds — how much it had to pay to borrow money — was just 1.44 percent. Needless to say, the average interest rate it charged the people it was lending to was a lot higher than that. In fact, though it’s hard to get exact data on this, it’s possible that, as Buffett said, the spreads on loans have “never been wider.” And when you combine that with the sheer number of loans these giant banks have on their books, you’re talking about individual banks earning tens of billions of dollars on their own.

Does that mean that the banks are fine? Not necessarily. The basic problem the banks face is that they need to recapitalize themselves. One way to do that is by taking their profits and, as it were, banking them. But the banks still have lots of old, bad assets on their books, and it’s possible that, as many predict, the value of those assets will fall more than their earnings will rise. And if the economy gets significantly worse, the increase in bad loans will probably cancel out the effect of wider spreads.

So why might most of the banks come out of this okay, without having the government nationalize them? One reason is that since most of these banks have slashed their dividends to pennies, every dollar they earn essentially goes to recapitalization, instead of going out the door to shareholders. And with the government looking over their shoulders, it’s also likely that the banks are going to be running tighter ships, so their expenses may be down as well. That’s why Buffett said on Tuesday: “I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital.”

The interesting thing about this prescription is that, in some ways, it’s precisely how the U.S. got out of its last big banking crisis, which happened during the recession of 1990-1991. While it hasn’t been talked about very much, during that recession most of the big moneycenter banks were, by today’s standards, insolvent — arguably more insolvent, in fact, than the big banks are today. They were not nationalized or put into receivership. Instead, after the Fed slashed interest rates, the banks hunkered down, cut back on risky loans, and allowed the wider spreads to work their magic, and over time earned their way out of insolvency. Today’s crisis is different in some important respects (in the earlier crisis, banks were able to make easy profits by investing in government debt, while today the profits on such an investment would be quite small). And there are some banks today which may be carrying so many bad loans that even their increased earnings power won’t save them. At the very least, though, history suggests that Buffett has not gone around the bend, and that it’s a mistake to think that nationalization is the only plausible solution to our current banking crisis.

Sign up for the daily newsletter.Sign up for the daily newsletter: the best of The New Yorker every day.